Tuesday, July 1, 2008

Hester: On Inflation Expectations

William Hester on the Hussman Funds web site with an excellent article on one half of the Red's rocck and a hard place. Include a chart and a couple of excerpts but the whole article is good.

If inflation expectations have taken the prominentrole in guiding future inflation, some difficult policy situationscould arise. It is generally expected that more slack in the laborforce should ease inflation. But Bernanke and Mishkin have argued thatinflation has become less responsive to the unemployment gap, whileinflation expectations have grown in importance. That means it may bemore difficult to lower inflation and inflation expectations once theybecome elevated. If inflation is less responsive to labor slack, moreslack – that is, higher unemployment - will be needed to lowerinflation (the measure of this tradeoff is often referred to as thesacrifice ratio).

This means that delayingconvincing actions that would show that the Fed can contain pricelevels would require a more severe response further down the road. Acredibly tough monetary policy would be a more manageable task if theeconomy was recovering from a recession, instead of what looks like theearly stages of a contraction. Add in credit markets wherecounter-party fear still dominates, an unemployment rate still rising,and a presidential race looming, and the Fed seems to be left with feweffective responses

Bernanke and crew are between credit collapse and rising inflation the solutions appear incompatible. I prefer they deal with the dollar for the following reason: a weak economy due to credit contraction and the collapse of housing speculation is a painful 2 or3 year problem, but loss of control of future inflation expectations is at least a decade long problem.Do a sudden coorddinated dollar intervention, send the message that is no longer going down. Make it worth investing in US assets again. It may hurt the economy more in the short term, but think of it as the quick sharp pain of a bikini waxing instead of the drawn torture of tweezers one follicle at a time.